Thoughts and Commentary on Socially Responsible Investing

August 28, 2008

Due to the emergence of new commitments and the growth of old ones, I am making my final posts to this blog in August/September 2008. This is the first of two brief essays on the philosophical justification for social investing.

The news appears good for us practitioners – social assets rose 18% over the past two years, compared with just 3% for the market overall.With one dollar in nine now managed according to some social constraint (mostly tobacco, still) social investing seems to have made a place for itself in the investment world.

And, from Wall Street and most of the famous business schools, a collective yawn.Now Wall Street has other things on its mind this year.But even as client interest has increased, my professional and academic colleagues remain mostly disinterested. And, disturbingly, the most indifferent people are often the most accomplished theorists and practitioners.

I recently realized that I have seen this situation before, in a completely different context . I hope the comparison will shed light on the intellectual obstacles social investors must yet surmount.

In chess, there is an opening call the Latvian Gambit.It is a violent response by Black to the most common first move by White, an attempt to turn the game into a desperate and deadly struggle from the outset.

It’s easy to describe: On the first move White pushes the pawn in front of the King forward two spaces.Black does exactly the same thing.Then White brings out the Knight next to his King, so it attacks the Black pawn.

This is the defining moment – Black can bring out his Queen’s Knight to defend the pawn (the most common choice, leading down well-traveled roads).Or, Black can counter-attack, bringing out the King’s Knight (this is called Petrov’s Defense, and it is very playable - Kasparov has scored successes with it).Or, Black can try something sort of crazy.In the Latvian the player of the Black pieces leaves the King’s pawn undefended, and charges forward two spaces with the pawn in front of his King’s Bishop.This opens up attacking lines for the Black Queen and dares White to waste time capturing the loose pawn in front of the Black King.It also opens huge gaps in the Black position, guaranteeing that however exciting the game will be, it will not be a comfortable one for the Black king.

What happens next is anyone’s guess, but the game will usually be tactically complex, full of cut-and-thrust action, with sudden death a real possibility for both players.

The Latvian has a loyal following, or cult, if you like.There are entire leagues of correspondence players who essay the Latvian against one another.It is certainly not in the mainstream: critics deride it as a ‘coffee-house opening’.But when you think about it, that means that in coffee houses all around the world, there are Latvian loyalists – people whose greatest satisfaction of the day is to push that impudent pawn to f5 and smile across the board at the opponent, as if to say – ‘we’re in for it now!’

But there is a problem, and the more serious you are about chess, the more serious it becomes.The Latvian is entertaining, but it is also almost certainly wrong – a loser against best play.The English Grandmaster John Watson has denounced it.The great American chess educator, Jeremy Silman, says simply:it’s bad.The only grandmaster work I have seen on the opening – Tony Kosten’s The Latvian Gambit Lives! - seems to acknowledge in places that if White plays a certain way, well, Black will probably lose.Yes, you can try it against your neighbor, or at your chess club, or even against pretty fair local competition - even Silman says it offers "good practical chances against an unprepared opponent."But it simply is not seen at the highest-levels of play.

Is this where we are with social investing?It is popular, yes, and apparently growing more popular each year.There is no shortage of people who pay lip service to it. But most of the strongest academics and practitioners still ignore it.Some theoreticians are sympathetic, especially on the behavioral side.But most of those with a strong quantitative bent simply cannot see how social investors can avoid incurring uncompensated risk.Financial economists (people like Chris Geczy or Brad Barber, for example) will tell you that constraints matter, and that social investment portfolios may be too constrained to achieve optimal results.So, no matter how sympathetic they might personally be, they are going to have a very tough time believing social investors can earn consistently strong returns relative to the market.

For the most part, with the single exception of the late John Templeton, the best practitioners are also reluctant to go along.Soros and Buffett have strong social consciences, but no apparent interest in social investing. The strong practitioners I know say: We’re playing a competitive game here.It’s a zero sum game, and you only get paid if you win.So if you are playing to win – ‘chasing alpha’ as the expression goes - you had better focus on the things that matter for returns.

You might point out to them that some of the things social investors care about do seem to matter for returns.You could show a few studies (Gunster, Barber, Edmans) that find positive performance effects.But you’ll just get a wave of the hand.Maybe, and maybe not, the practitioner says.You might be bringing me alpha.But you’re definitely reducing my options, and you’re definitely increasing my tracking error.In their world, and on their time horizon (usually less than a year), ESG doesn’t matter enough to change their behavior.

So, does that define the role of social investing?Social investors, if this analogy holds, are the club players of the investment world, trying hard and expending a lot of energy, and perhaps deriving some psychic benefits, but ultimately having no impact on the highest level of play.

I have long been an advocate of social investing because I believe values matter, and if values matter anywhere, they must be exceptionally important in business, where welath is created and most of us spend the majority of our waking lives.

But this analogy bothers me.The shoe fits better than I would like.Perhaps social investors can take comfort in the endorsement of a John Templeton or the sustained interest of a leading investment theorist like Meir Statman.But for each of these thoughtful people who are sympathetic to social investing, there are ten others who still think it is a dumb little sideshow.